Should I Buy An Investment Property? by Emily MurphySubmitted by Moller Financial Services on January 24th, 2019
Should I Buy An Investment Property?
“Should I buy an investment property?” This is a very common question we get from clients, and I’m going to walk through my thought process on how to decide if getting into real estate is right for you. The three steps to go through are:
1. Do The Math
A buyer is usually attracted by the steady income stream that comes from owning an investment property. If the rent covers the mortgage plus a little on top, the numbers may seem very attractive and make it feel as though someone else (the renter) is buying the asset for you (the owner). Is the math that simple?
There is a wealth of information from seasoned professionals out there on how to calculate profits in real estate investing so I won’t go in detail here. A concise overview of the numbers behind deciding if a property is worth owning can be found in this article written by an experienced real estate investor: https://affordanything.com/income-property/.
Let’s say you run the numbers and determine that between expected cash flow and appreciation, you anticipate the property will return on average 10% annually. But wait a second – what was that money doing before you bought the property? You’ll have to give up whatever return your money is earning or could be earning elsewhere before purchasing the property. Opportunity cost knocks again!
Historically, the US REIT index has averaged annual returns of about 12% (a REIT, or Real Estate Investment Trust, is a fund that invests in many different properties and mortgages)[i]. If a property isn’t returning at least as much as a broadly diversified REIT index fund, why not just invest your money in the fund instead?
Buying one (or two or three) properties is riskier than buying a fund that invests in thousands of properties. A mutual fund is also much easier, faster and cheaper to sell than a single investment property (liquidity risk). Extra risk means you should expect to earn well over the comparable index return before moving on in the decision process.
2. Don’t Forget Your Lifestyle
Investment properties are rarely “passive” income streams. Do you want to be a landlord? Do you want a job or a second job? Is your free time worth it? Hiring a property manager is an option for you if you didn’t answer yes to any of the previous questions. I’ve seen this option work well, but it needs to be factored into the cost ahead of time.
At the end of the day, buying a piece of real estate to rent out is a typically only a good idea for someone who enjoys and has a knack for home improvement projects. An investment property is a way to turn talent and sweat into financial equity. In my experience, this factor is what separates a successful landlord from a regretful one.
Real estate is different from most other investments you’ll likely make throughout your lifetime because it often requires so much more of your time and has the potential to disrupt your day-to-day life in unpredictable ways. It’s worth considering how much that is worth to you before jumping into real estate.
3. Do Consider Your Motivation
There are non-financial reasons that often influence the desire to buy hard assets like real estate. Given a choice between owning a stock in a company, even a real estate company, and owning a real piece of land, it has been my observation that most people gravitate towards the land. Why is real estate ownership such a pervasive desire when it’s usually difficult to justify with the math and it’s such a pain to own?
Real estate is tangible while stock in someone else’s company is not. It is easier to understand than the stock market for most people. You’re more likely to feel a sense of control over the outcome of your rental property than your stock portfolio. Could there be a sense of uncertainty or lack of control beneath the surface that is motivating the question?
While real estate investing typically isn’t as attractive when compared against equity indexes, it has historically fared better when compared against the returns of the “average investor”. In reality, the average investor tends to wildly underperform the indexes due in part to emotional investing and poor market timing decisions. Real estate can be a good option if you have a tough time staying the course with a more passive investment strategy. Of course, I think the best option is to work with your friendly neighborhood fee-only Certified Financial PlannerTM to help you instead.